Constructing Winning Stock Screens

This article originally appeared in the December 2012 issue of the AAII Journal.

When searching for stock investing candidates, it may be easy to come up with a list of meaningful screening criteria, but building and applying a cohesive set of criteria can be challenging.

Screening is the application of quantitative criteria to a broad universe of stocks in order to narrow the list down to a few companies. It allows you to focus your attention on a smaller but more promising group of stocks. It also forces you to use a consistent framework to decide which stocks to add or remove from your portfolio.

How do you design an approach or select a prebuilt stock screen that makes practical sense for you?

It is best to look at screening as a multi-stage process:

You must first clearly define the objective of your screen.

Next, you must construct primary criteria that locate the stocks that match your desired characteristics.

Then, you will need to construct a set of secondary criteria that ensure the companies passing the primary screen did so because they truly meet your objective and not by coincidence.

Keep in mind that even the best screen represents a starting point for in-depth analysis.

And last, you may wish to construct a set of criteria to highlight companies in your portfolio that no longer match the objective of your screen.

Defining a Clear Objective and Approach

An objective should always be established before constructing a screen. The objective should reflect your return objectives, risk tolerance and investment philosophy.

Return objectives encompass not only the total return, but the relative contribution of dividend income versus capital gains. Risk tolerance refers to how easily you can cope with volatility in an absolute and relative sense. Relative risk deals with the performance of a stock in relation to the market; whereas, absolute risk is concerned with the performance of a stock independent of the market. Investment philosophy encompasses the style an investor uses to select stocks.

For example, a young couple usually has little accumulated wealth and a long time horizon. They are seeking to build wealth and are willing to accept greater short-term risk (volatility) for the prospect of greater long-term returns. They might choose to focus their investment on smaller companies that have greater growth potential. On the other hand, a retired couple will likely have a shorter time horizon and will be more concerned with preserving their wealth. Therefore, they might choose to focus on stocks that pay greater dividends and have lower price volatility.

Clear, focused, narrowly defined objectives lead to the best screens. Some common broad screening objectives include seeking growth stocks, value stocks or even stocks with positive price momentum. But before the stock screening process is started, these broad objectives should be further refined to reflect the specific type of stocks that you are seeking and the best way to identify these stocks.

The young couple in our example may decide to seek growth stocks in the expansion stage of their life cycle with strong earnings momentum, understanding that the portfolio will have to be monitored carefully and the portfolio turnover is likely to be high. The retired couple in our example might seek out our undervalued companies paying above-average dividends, understanding that the portfolio will likely lag the market during strong bullish periods, but should decline less during bear markets.

With either strategy, there will be periods during which the portfolio underperforms other approaches. It is important to have conviction in the soundness of your approach to avoid jumping to last year’s hot trend just as it has already run its course.

Primary Screening Criteria

The primary screening criteria should flow naturally from your objective and should attempt to filter only those companies that meet your objective. If you are a growth investor, your primary screen should provide you with a list of companies that are in the growth stage of their life cycle, not mature cyclical firms. If you are a value investor, it does not make sense to spend time looking at stocks with uber-growth if they cannot be purchased at attractive prices. Good companies do not always make for good stock investments.

Screening criteria filter stocks by comparing a company’s numerical (“quantitative”) figures against some base figure. When defining your criteria, you will need to decide if you wish to compare on absolute or relative conditions. Relative conditions compare a company’s figure against a number adjusted for the current level of a company, industry or market benchmark. For example, you may be screening for companies whose price-earnings ratio is less than that of the S&P 500 index. As the S&P 500’s price-earnings ratio goes up, the screen will get less restrictive, allowing stocks with higher price-earnings ratios to pass.

Some criteria should only be used on a relative basis. Ratios such as price-to-sales, profit margins and turnover are very industry-specific and become meaningful only when compared to the norm for an industry or against a company’s own historical norm.

Screens that compare company data to other company elements or historical averages can also be useful. Because of growth prospects, some companies normally trade at a higher price-earnings multiple. Screening just for companies with price-earnings ratios below that of the market may lead to a collection of stocks with poor prospects and high risk that deserve low price-earnings ratios; such companies are not really underpriced. Using a relative screen that compares a company’s price-earnings ratio against its historical norm or against its expected growth (PEG ratio) may be a better way to point out potentially mispriced stocks that warrant a closer look.

Alternatively, you can choose to compare a company figure against some constant that does not fluctuate over time. An example would be a screen for companies with a price-to-book-value ratio below 1.0. As higher overall market levels lead to higher valuations for all stocks, the number of companies passing the price-to-book-value ratio will decrease. If market levels go to extremes, no suitable investments may pass the screen. Some value investors use absolute screens such as this to modify their exposure to the markets. During periods in which the market is priced rich, fewer attractive investments appear to replace the overvalued securities that have been sold, which leads to a net reduction in the equity allocation within the portfolio.

One of the biggest mistakes in criteria construction is having a list of criteria that are reasonable individually, but when combined turn out to be contradictory. If you are looking for potentially emerging high-growth companies in the early stages of their life cycle, then you should not team up a requirement for high earnings growth with a requirement for a high dividend yield. Companies that are truly growing usually need to use cash for expansion and can’t afford to pay high dividends. Combining the criteria in this way will negate the objective of the screen, probably leaving you with a list of oddball stocks that don’t really fit into any category.

By the same token, it is also a mistake to combine too many criteria filtering for the same type of companies. If you are looking for contrarian or out-of-favor stocks, screening for low price-earnings, price-to-book or price-to-cash-flow ratios will, for the most part, list the same type of stocks. Your screening efforts would be better spent focusing on the criteria that best indicate the type of companies you are seeking and on criteria that you really understand well. Each primary filter has its own nuances and tendencies. With clear-cut primary screening criteria, you can then add secondary criteria to capture the type of companies you are seeking.

Secondary or Conditioning Screens

Even with a clear objective and well-built primary filter, you can expect a number of companies to slip past your screen that do not embody the type of company you are seeking. Your high dividend yield screen will probably contain some companies ready to cut their dividend, and your historical earnings growth screen will probably capture some mature cyclical companies examined during their normal cyclical upturn.

While screening is designed to be a preliminary stage in the security selection process, the screening process should include a secondary, or conditioning screen. The conditioning screen should help establish that companies passing the primary screen did so because they meet the screen’s ultimate objective. These differ from the primary screening criteria in that, if used by themselves, they would not identify companies that meet your primary value or growth objective.

A primary screen for high-dividend-yield stocks may include a criterion for companies whose dividend yields are above that of the company’s five-year average high yield. This will lead to a list of companies with relatively high dividend yields. A conditioning screen would analyze those companies to help establish that the dividend is secure and poised to continue to grow, as opposed to being at risk of being reduced. The conditioning screen might include a criterion that specifies a maximum payout ratio (dividends per share divided by earnings per share) of 50% to seek out companies that are not paying out more than half of their earnings in the form of dividends. It is a conditioning screen for the dividend yield scan because, by itself, it does not indicate if the dividend yield is high or low, nor will it indicate if the stock is priced attractively.

Most screens should include conditioning screens that look for a minimum level of growth, profitability and financial strength.

Monitor Your Holdings

Screening provides a quantitative mechanism for selecting stocks, but it can also provide a decision framework for pruning your stock holdings. The criteria used to highlight passing stocks can be adjusted to highlight stocks in your portfolio that might be sell candidates.

The factors for selling should be decided in advance to avoid the emotional traps of selling, which range from “falling in love” with a company to avoiding the sale of a stock that is down because it forces you to admit that you made a mistake. Good companies can become bad stock holdings if they no longer match the objective of your investment approach.

Your quantitative sell rules should grow out of your objective and investment philosophy and will likely be related to your original rules used to select the stocks.

All Screens Are Preliminary

When designing stock screens, keep in mind that there are no miracle screens that produce lists of only guaranteed winners. A well-designed screen, however, should provide you with a preliminary list of stocks that hold some promise. A screening system also provides you with a framework to ask intelligent questions about the stocks you are considering as well as the stocks you currently own.

In developing a screen, keep the following points in mind:

Develop a clear, narrowly defined objective, keeping in mind the types of stocks that will meet your investment objective and philosophy.

Construct primary screening criteria that will locate stocks matching your objective. In constructing primary screening criteria, avoid using rules that cancel each other out or that are redundant.

Develop a set of conditioning criteria that will help ensure that a company passed the primary screen for a fundamentally sound reason and not just by chance.

Look toward your primary and secondary screening filters as guidance for monitoring your portfolio to ensure that the reason you selected a stock still holds true.

Remember that even the best-designed screen is only a preliminary search for investments using a small set of quantitative factors. A complete in-depth analysis that explores quantitative and qualitative factors should be employed. The fewer stocks that you hold in your portfolio, the closer you should examine and monitor each stock.